The Evolution of the Federal Reserve (1918-1944)

RETIRING GOLD

For both Eurodollars and liabilities of U.S. banks[,] . . . their major source is a bookkeeper's pen. - Milton Friedman, Nobel Prize in Economics winner, 1976

It only took half a century after the end of World War I for the United States to abandon its gold standard. The retirement of gold from our formal monetary system can be traced to a series of events starting with the great Wall Street crash of 1929. The 1920s, commonly referred to as the roaring twenties, was a decade defined by the first traces of consumerism: spending money as a way of life. Credit became widely available to the average American, but instead of measuring the quantity of its growth, it's more interesting to look at what type of credit was being issued. Department stores started offering credit cards to wealthy customers for the first time, oil companies began credit card loyalty programs, and banks fueled speculation in the stock market by lending up to 90% of the capital required to purchase shares. New York had become the center of international finance. Shares of companies listed on the New York Stock Exchange were flooded with demand, and capital poured into the United States. This greatly strengthened the global demand for dollars and bolstered the American currency to the world reserve currency echelon. The swarm of money creation that occurred during the roaring twenties was antagonistic toward gold's disciplinary constraint on money elasticity and conclusively revealed a societal need for the dollar's decoupling from gold. Categorically, there wasn't enough gold held by the United States government to furnish the elastic currency it had promised in its enactment. The proof of this came in the aftermath of a historic stock market crash.

When stock prices found gravity in October 1929, the Fed had to respond to a major financial crisis in earnest for the first time. With a fixed amount of gold reserves and a legally binding 35% gold-coverage ratio, the Federal Reserve was unable to create the necessary amount of second-layer money to stave off an economic depression. Several thou- sand banks failed in the early 1930s, wiping out billions of dollars of the American public's bank deposits. The economic depression coincided with the extremely harsh reality that third-layer money could disappear in an instant. No safety net or insurance mechanism existed to remedy such loss. The Fed did attempt to "furnish an elastic currency" and be a lender of last resort to the best of its ability, but it wasn't enough to overcome the effects of third-layer money contraction that resulted from the public's desire to flee risky deposits. The Federal Reserve was bound by a legislated minimum gold-coverage which limited the amount of credit the Fed made available to the system. Gold's disciplinary constraint received an outcry of blame for the economy's inability to recover and led to dramatic and sweeping changes to the dollar pyramid during the 1930s. These events should be seen as the major catalyst that kickstarted gold's departure from the world's monetary landscape.

No Gold for You

President Franklin Roosevelt issued Executive Order 6102 on April 5, 1933 which instructed all "gold coin, gold bullion, and certificates to be delivered to the government". The order was effectively a forced sale of gold in exchange for Federal Reserve notes (cash) by all United States citizens and out- rightly eliminated the people's access to first-layer money. This brazen declaration made the possession of and trafficking in first-layer money illegal and punishable by up to ten years in prison, reminiscent of the Bank of Amsterdam's mandate for all cashiers to surrender precious metal coins in exchange for BoA deposits upon its creation in 1609.

The following year, the United States passed the Gold Reserve Act of 1934, which devalued the dollar against gold by increasing the gold price from $20.67 to $35 per ounce. This immense devaluation was a surgical strike in an ongoing worldwide currency war wherein countries attempted to cheapen their currencies as much as possible relative to their trade partners. Their goal was to attract foreign demand by having the cheapest prices. The United States was merely copying what every other country was doing: giving anybody with gold more buying power to purchase American goods and services. Unfortunately for the American public, the gold price increase came after the seizure, meaning the American people didn't benefit from it. The Act also legally transferred the ownership of all Federal Reserve gold to the United States Treasury and preceded the physical movement of gold bullion from New York to the United States Army's installation at Fort Knox in Kentucky.

Deposit Insurance

The Banking Act of 1935 permanently established the Federal Deposit Insurance Corporation (FDIC), institutionalizing bank deposit insurance for the average American family. In the context of layered money, FDIC insurance is a federally guaranteed insurance policy on all third-layer bank deposits. The FDIC guarantee alleviated the public's fear of third-layer money vaporizing as it did during the 4,000 bank closures in 1933 alone. In numbers, the impact of the FDIC's creation was tiny: the insured amount for each depositor was only $5,000. But from a psychological standpoint, the impact was enormous. People wouldn't flee third-layer deposits in favor of second-layer cash if they knew their deposits were insured by the federal government. Without gold as an available savings vehicle, federal deposit insurance was the government's attempt to assure citizens that their dollar savings would be protected even if housed by private sector banks with counter- party risk. Around the same time, the Federal Reserve finally secured its official monopoly over note issuance after the U.S. Treasury paid off the last bonds eligible as backing for private notes. The once ambiguous dollar pyramid suddenly started to come into focus: the monetary system existed between the second and third layers of money, and gold's constraint on lower layers had been weakened by the government's actions between 1933 and 1935. Thus, began the journey for the U.S. dollar to stand alone, independent of gold.

King Dollar

Amidst the global currency war, the dollar emerged as the cleanest dirty shirt in the laundry of global currencies. Even though the dollar devalued against gold, other countries were doing so in an even bigger way. Pound sterling abandoned a gold standard in 1931 and officially ended its reign as world reserve currency. The void was filled by the currency of the world's newest superpower: United States of America.

In 1944, world leaders gathered at a hotel in Bretton Woods, New Hampshire and formalized that all currencies besides the dollar were forms of third-layer money within the dollar pyramid. The Bretton Woods agreement would come to be known as the dollar's world reserve currency coronation. The agreement didn't impact the relationship between the first and second layers of money in any way: Federal Reserve notes still promised the bearer gold coins on demand at $35 per ounce. It did pertain, however, to the relationship between the dollar and other currencies. Currencies would have fixed exchange rates with the dollar and wouldn't them- selves be redeemable for gold. Only the dollar kept a link between itself and gold. The dollar had become the axis of the world's various denominations. Governments and central banks across the world were forced to shift the denomination of their reserves, securities, and balance sheets to U.S. dollars (USD).

The agreement brought about an important distinction in the relationship between layers of money. Foreign currencies were on the third layer of money, this time not because of the balance sheet from which they came to exist, but rather because of their price relationship to dollars. In Figure 11, we show USD on a layer above other currencies such as GBP (British pound sterling) and CHF (Swiss franc). The pound and franc are below the dollar in the layers of money because their price is measured in dollars. This means that going forward, there are two possible relationships between monetary instruments within the layered framework: balance sheet hierarchy and price hierarchy.

Figure 11

Destined to Fail

Unfortunately for the international monetary system, the Bretton Woods agreement was doomed. The most prescient thinker on the burden of world reserve currencies during this era was Robert Triffin, a Belgian-born economist who conducted research at the Federal Reserve and International Monetary Fund in its early years. Triffin correctly predicted the end of the Bretton Woods agreement over a decade before it collapsed. While United States citizens were banned from owning gold, foreign nations were still allowed to convert their accumulated dollar reserves to metal. Triffin predicted that these nations would eventually deplete the United States gold stock, making a fixed price of $35 per ounce of gold impossible to maintain. He warned that gold convertibility would not survive without an adjustment to the framework held in place by the Bretton Woods agreement. Most importantly, he identified that being the world reserve currency was a burden, not a blessing. Foreign countries would accumulate dollars because of its reserve status. This would strengthen the dollar and cause trade imbalances that otherwise would not exist without this extra source of world reserve currency demand. Triffin's proposed solution to the problem of one country's currency serving as the denomination of the inter- national monetary system was political cooperation between major economic powers. In a testimony to U.S. Congress in 1959, he admitted his solution remained elusive, a dilemma that drove the demand for gold as the world's only neutral money, no matter how absurd the idea of it might be:

Source: Nik Bhatia: Layered Money
This work is licensed under a Creative Commons Attribution-ShareAlike 4.0 License.